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Nearing the Tipping Point

Pascal Blackburne & Luc Synaeghel2018-10-05

What if the main victim of US-promoted trade barriers were its own domestic economy? The European Central Bank recently made such a suggestion, which is also starting to be buttressed by economic data – be it in terms of the US trade deficit or inflation.

Pushing hard on the trade brake just as one is stepping on the fiscal accelerator certainly does not good to the US economic engine. America is not renowned for its propensity to save, meaning that fiscal policies designed to boost national income inevitably translate into greater consumption. And since the US are also not a production-centred country, much of this additional consumption has to be met by imports.

China, on the other hand, is awash with savings. They account for almost half of GDP, which – as per the basic economic premise that “saving equals investment” – means that more than USD 5’000 billion is available every year for productive spending. Better still, under Xi Jinping’s reign, China has become more focused on the efficiency of its investments, no longer ploughing money into ineffective state-owned enterprises or building up excessive capacity (e.g. in the steel industry). The New Silk Road project is a case in point.

Admittedly, some of the US claims regarding unfair Chinese trade practices are valid. But that does not make the retaliatory measures currently taken by the Trump Administration appropriate – nor timely. The suitable venue for reviewing trade rules should have been the World Trade Organisation, having first secured a united US/Europe/Japan front. And such negotiations should have taken place years ago. By pushing for stricter rules today, Western countries would effectively be shooting themselves in the foot.

Coming back to economics, beyond only serving to worsen the US trade deficit, the escalating US/China dispute is dampening world GDP growth expectations. Thus far, analysts have cut their estimates by only 0.1-0.2%, provided “all other things remaining equal”. Such an assumption may, however, prove optimistic. The problem is not so much the scale of current tariffs (i.e. their direct impact), but their potential (indirect) effect on business confidence.

And then there is the inflation issue. Higher tariff driven import prices are adding to already visible cost-push pressures in the US, coming notably from the wage and energy fronts. Inflation figures are now at the Federal Reserve (Fed) target – and headed higher. US monetary authorities are thus likely to deliver on their pledged tightening in 2019, contradicting current investor expectations. Emerging markets have already started to feel the pain of higher dollar funding costs. As US interest rates move up further, odds of a broader bond and equity market correction will increase – and the prospect of stagflation rear its ugly head.

Tariffs have actually worsened the US trade deficit

Source BCA, Bloomberg

We have previously written about the difficulty for US consumers to buy “made in America” goods. While the country is clearly very competitive in the services space and exports a number of commodities, it has fallen behind the curve in manufacturing. Therein lies the short explanation for why the Trump administration’s aggressive trade strategy is backfiring.

Indeed, according to the US Commerce Department’s latest report, the trade deficit reached a 5-month high in July, at USD 50.1 billion. This was its second straight monthly widening, and the largest since 2015 (see chart 1). Worse, the trade deficit with China surged to a record USD 36.8 billion.

However mistaken his stance on tariffs, President Trump is clearly unlikely to back down ahead of the US mid-term elections. Whether these elections then shift the political balance enough to make a difference on the trade outlook remains to be seen. If not, and once all imports of Chinese goods have been subjected to tariffs, what will happen then?

The risks stemming from higher inflation and interest rates

The belief in durably low interest rates appears to be deeply ingrained in investors’ minds. To the point that market expectations, as inferred from Fed funds futures, currently stand well below official Fed projections.

With inflation set to move higher in the US, under the joint influence of trade barriers, a very tight labour market and buoyant energy prices, we do not expect the Fed to deviate from its intended course of action. On energy, in fact, the near-term outlook is only made stronger by the reinstatement of sanctions on Iranian oil – not to mention the present lack of pipeline capacity out of the US Permian shale oil basin and insufficient export terminals at the US gulf coast.

In turn, rising rates could be the proverbial straw that breaks the back of financial markets. Each of the last three major corrections was preceded by a sharp rise in bond yields (see chart 2). To quote BCA Research, such a move “flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated”.

Source Bloomberg

So far, damage has been largely confined to emerging markets. But with a severe and broader-based stock market correction would likely come a downturn in the world economy, particularly since business confidence has no doubt already been dented by the trade tensions. We note for instance some hesitations on the part of bulk shipowners to invest in new vessels, even though freight rates remain very strong.

The combination of slowing global growth and rising inflation – known as stagflation – is thus unfortunately becoming a distinct possibility.

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